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Singling Out Defence Procurement: Contract Pricing under the Single Source Contract Regulations

By Dr Luke Butler, Lecturer in Law (University of Bristol Law School).

Whatever the fallout of Brexit, the UK will continue to take a leading role in the defence of Europe. In an age that will be defined by reduced defence budgets and increased security threats, the Government must ensure that the way it organises, procures and manages its defence capability delivers value for money. Historically, the legal aspects of defence acquisition have been largely underresearched. My latest monograph, UK Defence Acquisition: Organisation, Process and Management (Hart Oxford, forthcoming) will offer a first systematic analysis of an area currently undergoing unprecedented domestic legal reform. This blog focuses on efforts to regulate the escalating costs of defence contracts.

Context

In my last blog, I highlighted that the EU Defence Directive’s attempt to open up defence contracts to EU wide competition has done little to prevent 90% of defence contracts being awarded to national contractors.[1] Whilst some may have been awarded contrary to EU law, EU law does exceptionally permit awards to individual suppliers on a non-competitive basis on certain grounds.[2] On the assumption that such awards might be legally justified, the Government considers that at least 45% of the Ministry of Defence’s (MOD) procurement budget will continue to be spent on non-competitive single source contracts.[3] However, awards to national suppliers without competition could impact value for money. Opportunistic incumbents may raise costs in the absence of a rival bidder and knowing the Government’s dependence. The public sector may also lack the resources to negotiate, investigate and reduce costs.

Historically, the pricing of defence contracts has largely remained legally unregulated. The 1968 Government Profit Formula (“Yellow Book”) required parties to provide “equality of information” on costs as well as the possibility (rarely exercised) for “post-costing”, allowing the MOD to claw back “unconscionable profits” years into the performance of a contract. The known weaknesses of the Yellow Book were finally conceded in Lord Currie’s 2011 independent review of single source pricing.[4] It was found that, ultimately, it is not necessarily that defence contractors earn excessive profits (comparable to other sectors); rather, the Yellow Book focused too much on determining the appropriate profit rate and rectifying excess costs after the event and too little on ensuring discipline in the cost base (on which the profit rate is charged) at the outset. Consequently, the absence of cost-realism affects contract budgeting, planning and management and renders it difficult to accurately assess prices and profits. Moreover, it was clear that the Review Board for Government Contracts tasked to oversee the Yellow Book regime was ineffective.

Single Source Contract Regulations in Outline

In 2014, the UK adopted the Defence Reform Act (DRA) which, in turn, enabled the Single Source Contract Regulations 2014 (SSCR).[5] This fundamental reform has replaced the Review Board for Government Contracts with a newly appointed regulator, the Single Source Regulations Office (SSRO). The SSRO is an arms length body (but sponsored by MOD) tasked to ensure that value for money is obtained on non-competitive contracts and that suppliers are paid a fair and reasonable price.[6] In turn, the SSRO oversees a new set of single source pricing regulations which replace the Yellow Book. A full explanation of defence contract pricing under the regime would deter even the most assiduous reader so I’ll confine exposition to a basic overview of the key features.

Relative scope

Just to clarify, the process by which a non-competitive contract is awarded i.e. “procured” remains regulated by the Defence and Security Public Contracts Regulations (DSPCR) and EU law.[7] The SSCR regulates the pricing of that awarded contract as a matter of domestic law. The SSCR apply to so-called “qualifying defence contracts” (QDCs), namely, a single source contract of £5 million or above placed on, or after, 31 March 2015.[8] The SSCR also applies to “qualifying sub-contracts” (QSCs), a contract supporting the QDC valued at £25 million or above.

Pricing principles

The SSCR’s core principle is that the price to be paid for defence capability should be fair and reasonable. Expressed as a calculation, the basic formula is: contract price = (contract profit rate x allowable costs) + allowable costs. Reduced to its essentials, the first key element of the equation is the contract profit rate. This is calculated according to a six step methodology as follows: (1) identify a baseline profit rate (set by the SSRO); (2) apply an upward risk adjustment if necessary; (3) apply a downward adjustment for profit once on contract; (4) apply an SSRO funding adjustment (contractors will pay a percentage to ensure the SSRO’s functioning); (5) a discretionary incentive adjustment for exceptional performance; and (6) a capital servicing allowances adjustment (recovery for reasonable fixed and working capital costs).[9] The second key element concerns: “allowable costs”. Allowable costs are costs that are determined to be “appropriate, attributable and reasonable” with the onus probandi on the contractor.[10] To assist, the SSRO has issued statutory guidance on what might constitute an allowable cost.[11]

Contract Reporting

In order to ensure cost discipline from award through performance, the SSCR also imposes minimum legal reporting requirements on contractors at the start of, and during, the contract[12] as well as a statutory duty to keep records relating to costs on the contract.[13] In addition, MOD has rights of access to those records, for example, where there are concerns regarding pricing assumptions or to get clarity on any developing cost variance during the life of the contract. A post award review may also be conducted to test pricing assumptions early on in the contract. All of these requirements are intended to make MOD an “intelligent customer”, that is, to enable it to make more informed decisions based on better comparability assessments of how different types of contracts are costed by different suppliers across the board. Certain protections run alongside these rights and obligations. If MOD has not used its inspection rights reasonably, a contractor can refer a matter to the SSRO for a determination. To further assuage industry concerns, a new criminal offence has also been introduced for unauthorised release of confidential information.[14]

A few observations

Given that the DRA and SSCR received broad parliamentary support (as well as general support from industry), there have been few objections to the regime in principle. However, in my view, there could have been more informed debate on the merits and demerits of legally regulating this area given that a voluntary non-statutory regime was originally envisaged.[15] Blind faith in legislation as the appropriate tool after years of loose governance also begs broader questions: why stop at legislating non-competitive contracts? Why not legislate contract pricing of competitive defence contracts or all procurement contracts? It is beyond the scope of this blog to consider these issues. Accepting the legal model now in place, it must be acknowledged that there is potential for the SSCR regime to achieve real savings for the taxpayer. For financial year 2015/16, the SSRO received notification of 30 + QDCs valued at £11.5 billion.[16] However, 127 single source contracts were not (or not properly) classifed as single source but were valued at £840 million.[17] Therefore, if savings are to be realised, the number of contracts being notified needs to increase.

A number of other issues are also beginning to surface, just some of which are outlined here. Firstly, the SSRO is already facing the same criticisms that have dogged the MOD’s civil service for years: lack of independence and transient leadership. Fears about the SSRO’s independence from both industry and MOD do not appear to have materialised but will always require close monitoring. More worryingly, the SSRO’s first Chair resigned after less than two years. The Chair expressed public concern that too few contracts were being notified.[18] Perhaps the Chair’s ambitions for the SSRO regime were too high; other reasons for departure would be speculation. An interim Chair (a lawyer) has since been appointed. At this stage, it is unclear to what extent, if at all, this is a strategic move or will coincidentally take SSRO governance in a more “legalistic” direction in terms of how the SSCR are formulated and interpreted, how the SSRO reaches and publishes its determinations (reading like judgments?) and envisages its enforcement role qua “regulator”.

Secondly, there is legal uncertainty regarding the SSCR’s scope. For instance, the SSCR do not appear to apply to the pricing of sole source contracts awarded to foreign suppliers through foreign military sales.[19] It is also recalled from my previous blog that the DSPCR also prima facie exclude such contracts. Thus, both the procurement and pricing of foreign sourced contracts are subject to limited oversight. UK industry is also likely to express concern about having to comply with a regime not applied to foreign contractors and which may impact their competitive position. Another issue is whether the thresholds above which a contract constitutes a QDC should be removed altogether, not least because a number of single source contracts fall below £5 million. The list goes on…

Thirdly, there is still some uncertainty in the statutory pricing formula. Concerning allowable costs, the SSRO has recently issued its first determination finding inter alia that Rolls Royce could not claim that certain marketing and sales costs were allowable costs.[20] However, this was not exactly a hard case: attempts to pass off costs that improve the company’s commercial profile are unlikely to fly. The SSRO is yet to be tested with a genuinely borderline case. Concerning the baseline profit rate, it has become clear that a single baseline profit rate is not suitable for application to all contracts and that multiple rates may be necessary to reflect differences of type and complexity. Initially, there had been concern about the introduction of multiple rates, not least the limited resources available within MOD to manage their variable application.[21] Notwithstanding, the SSRO has recently approved multiple baseline rates.[22] If it is difficult to determine allowable costs and profit rates, contractors are likely to experience similar difficulties in estimating cost risk and the types of capital servicing adjustments that are possible under the formula. It must be acknowledged that initial uncertainty is to be expected as the SSRO refines its approach through guidance and determinations. However, it is equally important to acknowledge that the SSRO’s guidance is not advisory but statutory. Ultimately, any legal uncertainty is to be determined by the SSRO in the first instance and only further confirmed through a referral for its determination. Further, revisions to the Guidance are not being published after a periodic review but, rather, sporadically as and when the need arises. This enables an adaptable approach but which is not necessarily conducive to legal certainty. Contractors may also be reluctant to refer contracts to the SSRO for assessment because no contractor wants to have their contract costs exposed as non-compliant.

Fourthly, the SSRO has itself expressed concern about its limited enforcement role. The SSRO can recommend compliance or penalty notices but enforcement is left to other MOD components, for example, the Secretary of State.[23] The SSRO considers that there are “compelling reasons” for greater enforcement powers not least when compared to other economic regulators such as the Financial Conduct Authority.[24] Whilst there are arguments for, as yet, potential arguments against have not been considered and which I’ll develop in more detail elsewhere. Reflecting on just some, the more formalised a process becomes (typified by serious sanctions), the greater costs that might be incurred. If a contractor feels that the regime requires an army of lawyers to defend its costs, such legal costs may ultimately be factored into its prices by some other means and which is counterintuitive to the regime’s objectives. Contractors may also be less inclined to take risks in pricing and which might reduce its overall competitiveness and value for money, again, potentially undermining the SSCR’s rationale. Another is that other economic regulators, drawing on their own experiences in their sectors, might well advise caution in favour of compliance measures and against prosecutorial sanctions.

Fifthly, whilst not necessarily a criticism, the fact that the SSRO model is referrals-based has certain consequences. It is ultimately dependent on the willingness of contractors to comply with the SSCR regime and identify costs for determination. Even on referral, it is clear that contractors are reluctant to fully substantiate all of their costs.[25] More generally, the SSRO has a fairly limited budget and a staff of only 30 or so which may further limit its investigations.

Overall, the SSCR regime marks a positive development but should be seen as part of a wider set of systemic issues. Contract pricing is just one aspect that needs to be addressed alongside strategies for effective contract planning (through defining requirements) and contract execution (management). It is now a case of making the regime work as the SSRO negotiates a via media between industry and the MOD, all of which are adapting to unprecedented political and economic change. As ever, please feel free to contact me either through the blog space or in private correspondence to discuss issues raised.

[2] For example, it is possible to do so where an award for replacement goods to anyone other than the original supplier could result in incompatibility or disproportionate technical difficulties. See Defence and Security Public Contracts Regulations, Reg.16. Further, Article 346 TFEU (the essential security interest derogation) may also be invoked to justify a domestic award to ensure the continued viability of a national industrial capability.

[3] Based on data from the FY 2007/8 – 2011/12. See Ministry of Defence, An Overview: Single Source Procurement Framework, Version 1.0 June 2014, p.1. It is, as yet, unclear whether/to what extent this number will increase as a result of Brexit.

[4]Review of Single Source Pricing Regulations, October 2011, An independent report by Lord Currie of Marylebone. Further endorsed in Ministry of Defence, Better Defence Acquisition, Improving how we procure and support defence equipment, June 2013.